Data Driven Days - Derivative Dangers

Monday, September 12, 2005

Starting with a benign Monday without any expected major economic news releases market participants are likely to dance on the tips of their toes for the rest of the week with a bagful of economic indicators that could have the power to move all markets - currency, equity, debt, gold - significantly.
As if the pile of indicators were not enough the Fed New York has summoned the heads of derivatives trading of the 14 biggest players in the multi-multi-trillion market for a meeting on Thursday. This unprecedented move raised a lot of speculation about whether there is something in the bush in this market that is ballooning at a speed and mostly off-balance sheet that makes it hard to define its sheer size.
Estimates for the global derivatives market range from $8.4 to $84 trillion which already gives you an idea that nobody really knows how much risk is out there. For comparison: Total US stock market capitalization lies at around $14 trillion.
JPMorgan Chase & Co., Deutsche Bank AG, Goldman Sachs Group Inc., Morgan Stanley and Merrill Lynch & Co. dominate the credit-derivatives market as the five most-cited trading partners, according to Fitch Ratings.
Seeing now about one hedge fund collapsing each week - either by fraud or simply by bad trading - there is reason to suspect that even one of the major players or their counter-parties could be at risk. It has to be noted that the major banks around the globe derive ever growing parts of their profits from issuing or trading highly complex derivatives instruments or from lending money to hedge funds who funnel it in these instruments, looking for above-average returns. As we know - where there is a winner, there must be a loser. Look out for any news about this conference which certainly is not a run-of-the-mill event. The Fed's letter to the banks said "a senior business representative and a senior risk management person" should attend the meeting initiated by Fed New York president Timothy Geithner.
Some of the Fed's concerns about derivatives markets, lengthily voiced by Fed chairman Alan Greenspan in May, may also show up in a speech of Fed governor Mark Olson that focuses on "Business Trends and Management Challenges for the Banking Industry". Olson will speak on Friday.
Data Pile
While Monday starts out as a benign day with no US economic indicators scheduled, Tuesday's trade deficit figures could bring a new record thanks to rocketing oil prices which might also get reflected in producer prices the same day and consumer prices on Thursday. Malicious note here: The so-called core numbers will not show a sharp rise. But they only concern people who neither eat nor drive.
US inflation

US inflation has been on an upward trend since 2002. Chart: Courtesy Econoday.
The Treasury budget will be of minor concern as the desaster from hurricane Katrina will only show up in future budget figures. Estimates for the cost of Katrina are ballooning every day. As soon as Congress passed immediate relief money at a level of $52 billion, total cost estimates today lie closer to $300 billion.
On Wednesday industrial production is expected to come in a notch higher; but don't forget that this is still a pre-Katrina figure and therefore meaningless for the future outlook. Retail sales are expected to have declined in August.
On Thursday the all important consumer price index (CPI) is seen at plus 0.5 percent. That is for mere mortals. Those who eat indexes in their dark and cold/hot homes will see their cost of living only 0.2 percent higher than a month ago. Note: If the CPI rises again 0.5 percent this turns out to be an annual rate of 6 - repeat 6 - percent annually at a time when wages are stagnating.
Friday is designed as a dollar versus the rest day. Both the current account deficit figures and the Treasury International Capital data are scheduled for a day that ends indicatorwise with consumer sentiment figures.
All US Data At A Glance
C=Consensus estimate; L=Last
International Trade July: C: minus $60 billion; L: $58.8 billion
Producer Price Index: C: 0.7 %; L: 1 %
Treasury Budget: C: minus $50 billion; L: minus $52.8 billion
Retail Sales: C: minus 1.4 %; L: plus 1.8 %
Retail Sales ex Autos: C: 0.5 %; L: 0.3 %
Industrial Production: C: 0.2 %; L: 0.1 %
Capacity Utilization: C: 79.8 %; L: 79.7 %
Business Inventories: C: unchanged; L: unchanged
Consumer Price Index (CPI): C: 0.5 %; L: 0.5 %
NY Empire State Index: C: 18; L: 23
Jobless Claims: C: 350,000; L: 319,000
Philadelphia Fed Survey: C: 14.0; L: 17.5
Current Account Deficit Q2 2005: C: minus $194.5 billion, L: minus $195.1 billion
Treasury International Capital: No consensus; L: $ 71.2 billion
Consumer Sentiment: C: 85.0; L: 92.7
All together the data outlook does not exactly project a week of cheers. But observations of equity and debt markets in the recent past conjure the picture that these markets can take everything from war to natural desaster, thanks to the Federal Reserve pouring ever more liquidity into them. I have reserved this issue for tomorrow's post.


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